Portfolio & asset classes
In the previous segment of the Basics of Investing and Portfolio course, we introduced you to the world of finance. We saw what investing is about, why it is important and the two main types of investments: Stocks and Bonds. Also, we started two really important topics, which are compound interest and risk. All this provided a solid base for us to move on to more exciting and useful topics.
In this segment, we will learn what a portfolio is and how to manage it while controlling risks; and in this particular section, we will start talking about what a portfolio is and the different types of asset classes you may find.
What is a portfolio?
A portfolio is simply all the assets that you own (which you bought and haven’t sold). Imagine you own 10 stocks of Microsoft, 5 stocks of Apple and 5 bonds. That is your investment portfolio. Even if you own 1 single stock of Apple, that would still be considered a portfolio. Portfolio is a fancy word to describe a group of assets that you own. If you think about it, most photographers, painters, and designers have portfolios with all the work they make; an investment portfolio is the same idea, only with investment assets, rather than with pictures or paintings.
As you see, the idea of a portfolio is very simple. A group of assets (or a portfolio) will behave like its own. The magic comes in knowing how to manage your portfolio well. In simpler terms, portfolio management is finding the right combination of assets to match your characteristics as an investor, such as your risk tolerance or your long term objectives. Like any painting or photography portfolio, a proper investment portfolio should have a set style and strategy that match the owner’s personality.
First, let’s see a clear definition of what an asset is. It is a resource (or investment) you own that has economic value, which you expect will provide a future benefit. An asset class refers to investments that have a similar behavior over time. To clarify this, let’s look at an example:
Remember Laura and her SmartPie company? Well, all these years in the pie industry provided her with $1,000,000 to invest in other assets. So she decided to invest as follows:
- Opened SmartPies, Inc. –> yielded $1,500,000
- $1,000,000 to invest in other assets
- $500,000 left in the business
- Opened a baguette bakery: $500,000 –> initial investment (50% of her investment capital of $1 million)
- Bought a rental property: $500,000 –> initial investment (50% of her investment capital of $1 million)
Both of these investments are very different. They require different levels of dedication, are affected differently by the economic forces, and will most likely behave differently over time. However, if we think about it, the baguette bakery and SmartPies are both companies in the baking industry; therefore, we can think of them as being part of the same asset class, since they are likely to behave similarly. On the other hand, the rental property would be part of a different asset class. Let’s see then how these three investments will perform in the next 10 years:
The above graph shows the behavior of the three assets (SmartPies, Baguette bakery and Rental Property) over the next 10 years. We can see how both the blue and the orange lines (baking companies) are very similar, both assets fluctuated significantly and behaved similarly; on the other hand, the grey line (rental property) grew steadily and ended above the others, which means that it ended up being the most valuable.
This is a simple example to show how different asset classes behave differently in general. This opens the gate to many topics that we will explore in future sections, such as asset allocation, correlation, etc.
Asset Classes & Subclasses
There are many types of assets, and in the previous segment, we saw the two main assets, stocks and bonds: stocks are also known as equity or partial ownership of a company; and bonds are like “backward loans”, debt that a company owes you. We also saw that stocks generally have a higher expected return than bonds, which is necessarily linked to higher risk, and it means they behave differently. Again, this opens up the idea of asset classes, assets that behave similarly and have similar characteristics. Logically, we conclude that stocks and bonds are the two main broad asset classes. However, stocks and bonds have many subclasses, which are different groups of investments within an asset class.
Each member of a subclass shares distinctive characteristics and qualities with the other members, such as the size of a company, its business strategy, its business sector or type of entity that backs the investment. We have only seen two examples of stock subclasses so far: growth stocks and dividend stocks. The components of these subclasses have different underlying business strategies. Other examples would be small-cap and large-cap stocks, Treasury or corporate bonds, and many more that will see in future sections.
In the next section, we will introduce the idea of asset allocation and we will start looking into why it is useful to manage risks.